Durians and diversification

November 17, 2018

TAKEAWAY OF THE WEEKWhat diversification is not

There are some things we can all agree on. Books are more enjoyable to read in paper form. Durian should be a superfood. Also, that diversification is a good thing. It’s an investment principle that we all know we should be following. Who doesn’t want to take less risk and enhance their portfolio returns at the same time (a.k.a a free lunch? (You can read more about the benefits here)

But we also need to understand what diversification is not:

1) You can’t diversify your way out of a financial stormHaving a diversified portfolio will not protect you from market volatility in the short-term - you will still have big down days or even consecutive months of losses. It will not prevent bear markets and it cannot protect you against market reactions to Trump’s latest Tweet. Diversification may or may not help in the short-term, but it’s really a strategy for the long-term investor that will help you smoothen out returns over market cycles.

2) More is not always better Having a portfolio with more components does not mean that it’s more diversified. This might be true if all the asset returns are uncorrelated (i.e. the prices do not rise and fall together), but this is unlikely to hold true. Also correlations are constantly changing, even assets that were uncorrelated in the past may be in the future.

Each asset you hold is less important than how they interact together (known as covariance) to reduce your portfolio’s overall risk. The marginal benefit of adding another investment decreases past a certain point . This means adding a 20th fund to your portfolio will probably not meaningfully improve risk-adjusted returns, and your advisor might just be building you a very complex portfolio to justify their own existence and high fees.

3) Diversification is not exciting In fact, it’s pretty dull to talk about a portfolio that gives you globally diversified exposure to the world. You’re not going to hit any home runs like Amazon, but you’re also less likely to strike out with all your life savings in Lehman Brothers. You can leave the excitement to other parts of your life - being able to live the life you want after retirement is exciting, but the path to growing your retirement nest egg to get there doesn’t need to be.

Diversification is a strategy that plays out over a long period of time, and give you a greater chance of achieving your goals without having to predict how the future will turn out. As Howard Marks said:

“You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term.”